Fixed-income investments, such as corporate and government bonds and money market investments, have a place among your investments, whether you are just starting out or about to retire.
The reasons why you should consider including them, in line with your investment goals, are:
Investing in bonds
Bonds are a key investment in the interest-bearing sector. These are essentially loans to governments, utility providers such as Eskom, or private companies. The loans are divided up into bonds and sold on auction to investors.
Bonds pay interest over the term of the loan – monthly, quarterly or twice a year - and pay back your investment at the end of the term, or at the end of the term they pay you back more than you initially invested.
You can invest indirectly in bonds as you can in shares, but typically the investment amounts are too high for ordinary investors – a million rand or multiples thereof.
Unit trust fund managers using investors’ pooled money, are, however, able to invest in bonds. As investment professionals, they also know how to buy and sell bonds on the bond market.
Bonds are sold in what is known as the primary bond market at auctions. They are typically bought by primary brokers at the likes of banks that sell them on to investors – individuals or asset managers.
You can buy and hold a bond to maturity, but typically investors buy and sell bonds before they reach maturity in the secondary market.
On the secondary market, bonds may cost more or less than the amount for which they were originally sold.
The price of the bond depends on what investors are prepared to pay for the bonds. This in turn depends on investors’ views on:
Professional investors, such as unit trust fund managers, take a view on where rates are going and on the risk of default. They decide what is a good price at which to buy or sell bonds. In this way they can make a capital gain or loss on a bond.
Other interest-earning instruments
Fixed interest fund managers also invest in a variety of interest-bearing instruments that are issued by governments, banks or parastatals that pay interest. These include:
Investors in all of these instruments must assess the risk of the issuer defaulting – the credit risk and the risk of earning less than future interest rates.
However, on money lent over a short term, the risks are generally lower as investors have more certainty about interest rates and the risk of the issuer defaulting than they do over longer periods.
Some bonds have very long terms to maturity – for example, 30 years. This can make it difficult to call how valuable the bond may be in the future and makes bond investments more risky.
Unit trust funds in the fixed income sub-categories have therefore been classified according to the terms to maturity of the instruments in which they invest.
Money market funds
The least risky funds are the money market funds and they can only invest in fixed interest instruments with a term to maturity of less than 13 months.
The average term to maturity - or what fund managers call the duration of the fund's holdings - may not exceed 90 days and the weighted average duration to maturity of all the holdings may not exceed 120 days.
When you invest in a money market fund for every rand you invest you can expect that in most cases you will receive the same rand amount back when you want to withdraw – your capital is reasonably secure.
The only time you may lose money on a money market fund is when a bank fails and cannot honour, or honour in full, the instruments issued to investors.
You will also receive interest the fund is paying. The interest can be paid to you when it is distributed or you can reinvest it to increase the amount you invested.
The interest paid by money market funds is typically higher than the interest you will receive on a bank deposit that is not fixed or tied up for a certain period.
The interest rate will change if the central bank – the South African Reserve Bank in South Africa – takes the interest rates up or down.
Short-term interest-bearing funds
Investors who are prepared to take a little more investment risk can invest in other interest-bearing funds and potentially earn a higher interest rate.
These funds are classified as short-term interest-bearing and can invest in interest-bearing instruments with any term to maturity as long as on average the terms to maturity (duration) do not exceed two years.
Bond funds are the third kind of fixed interest funds and these can invest in fixed interest instruments of any duration. They fall under the fixed interest variable term sub-category, because fund managers typically vary the duration of the fund depending on the interest rate cycle and the bonds they think will offer the best returns.
